pre-budget scrutiny 2020-21€¦ · policy spillovers _20 personal allowance _20 additional...

Published 12 November 2019SP Paper 619

9th Report (Session 5)

Finance and Constitution CommitteeComataidh Ionmhais is Bun-reachd

Pre-budget scrutiny 2020-21

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ContentsIntroduction ____________________________________________________________1

Economic Performance __________________________________________________2

Scottish Income Tax 2017/18 – Reconciliation Process ________________________5

Earnings Growth _______________________________________________________8

Welsh Fiscal Framework ______________________________________________13

Managing the Risk ___________________________________________________15

Transparency _______________________________________________________17

Data ______________________________________________________________19

Policy spillovers _______________________________________________________20

Personal Allowance ____________________________________________________20

Additional Dwelling Supplement __________________________________________22

Context______________________________________________________________22

Operation of ADS______________________________________________________23

VAT assignment________________________________________________________25

Conclusion____________________________________________________________28

Bibliography___________________________________________________________29

Finance and Constitution CommitteePre-budget scrutiny 2020-21, 9th Report (Session 5)

Finance and Constitution CommitteeTo consider and report on the following (and any additional matter added under Rule 6.1.5A)—(a) any report or other document laid before the Parliament by members of the ScottishGovernment containing proposals for, or budgets of, public revenue or expenditure orproposals for the making of a Scottish rate resolution, taking into account any report orrecommendations concerning such documents made to them by any other committee withpower to consider such documents or any part of them;(b) any report made by a committee setting out proposals concerning public revenue orexpenditure;(c) Budget Bills; and(d) any other matter relating to or affecting the revenue or expenditure of the ScottishAdministration or other monies payable into or expenditure payable out of the ScottishConsolidated Fund.(e) constitutional matters falling within the responsibility of the Cabinet Secretary forGovernment Business and Constitutional Relations.

http://www.parliament.scot/parliamentarybusiness/CurrentCommittees/Finance-Constitution-Committee.aspx

[email protected]

0131 348 5215




ConvenerBruce CrawfordScottish National Party

Deputy ConvenerAdam TomkinsScottish Conservativeand Unionist Party

Tom ArthurScottish National Party

Neil BibbyScottish Labour

Alexander BurnettScottish Conservativeand Unionist Party

Angela ConstanceScottish National Party

Murdo FraserScottish Conservativeand Unionist Party

Patrick HarvieScottish Green Party

Gordon MacDonaldScottish National Party

John MasonScottish National Party

Alex RowleyScottish Labour

Committee Membership


Introduction1.

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4.

At our meeting on 5 June the Committee agreed to focus its pre-budget scrutiny(2020-21) on the operation of the Fiscal Framework, building on its previous work inthis parliamentary session. Since the publication of the Committee’s report onBudget 2019-20, a number of documents have been published which are relevantto the operation of the Fiscal Framework and which have been useful in informingthis pre-budget report—

• Scotland’s Fiscal Outlook: The Scottish Government’s Medium Term Financial

Strategy 1

• Scottish Fiscal Commission Economic and Fiscal Forecasts 2

• HMRC Scottish Income Tax Outturn (2017-18) 3

• Fiscal Framework Data Update 4

• Scottish Fiscal Commission Forecast Evaluation Report 5

• Fiscal Framework Outturn Report 6

In July 2019, HMRC published outturn figures for Scottish income tax for 2017-18.This is the first time a full year of outturn data for Scottish income tax has beenavailable since the power to set rates and bands for non-saving, non-dividendincome tax was devolved to the Scottish Parliament. It is, therefore, also the firstyear of the operation of the reconciliation process for income tax. This reportfocuses on the operation of this process.

As part of the new budget process, the Committee has continued its full yearapproach to budget scrutiny including the following areas—

• Earnings in Scotland;

• Additional Dwelling Supplement;

• VAT assignation;

• Policy spillover provisions within the Fiscal Framework.

This report also provides an update on the Committee’s work in these areas.


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Economic Performance5.

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8.

The Committee notes that a key element of the Fiscal Framework is that it isintended to incentivise the Scottish Government to increase economic growth

relative to the UK economy. 7 There is an expectation that if the Scottish economyoutperforms the UK economy that this will benefit the size of the Scottish Budgetthrough a higher increase in devolved tax revenues relative to the rest of the UK.Audit Scotland explain that—

The Fiscal Framework is intended to incentivise the Scottish Government toincrease economic growth. Where the Scottish economy is performingrelatively well, tax revenues will be higher and pressures on spending will ease.Where it performs relatively less well the effect will be to squeeze the budget,reducing available funding and increasing spending demands.

The SFC told us in June 2019 that the “Scottish economy has been particularlystrong over the past two years. In the main that has been driven by a strong net

trade performance, which, in part, has been driven by the depreciation in sterling.” 8

The Scottish Government’s Medium Term Financial Strategy (MTFS) states that“2018 was a positive year for the Scottish economy, with growth relatively broad-based across the economy; the labour market delivering record levels of

performance; and further growth in exports.” 9 The Cabinet Secretary told us inJune 2019—

our exports are on the rise, outperforming exports from the rest of the UnitedKingdom, and our foreign direct investment is second only to London and thesouth-east of England. Income tax is rising and earnings growth is on the up inreal terms. Those are strong economic indicators and foundations.

Source: Finance and Constitution Committee 12 June 2019, Derek Mackay, contrib. 1210

Table 1 below provides the outturn figures for GDP growth in Scotland and the UK for2017/18 and 2018/19.


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Table 2: Forecast Income Tax Reconciliations

Outturn Data Available Budget Affected Reconciliation (£m)

2017-18 Summer 2019 2020-21 -204

2018-19 Summer 2020 2021-22 -608

2019-20 Summer 2021 2022-23 -188

Source: Scottish Fiscal Commission

12.

Table 1 - GDP Growth Outturn Figures

Source: SPICe

Table 1 shows that UK GDP growth outperformed Scottish GDP growth in 2017/18both in overall terms and per capita. However, in 2018/19 the Scottish economymatched the overall performance of the UK economy and was stronger per capita.There may be some expectation, given the economic growth incentive built into theFiscal Framework, that the Scottish Budget would to some extent be worse off in2017/18 but would be better off in 2018/19.

However, this is not the case. As this report demonstrates, it is too simplistic toassume that faster relative economic growth will result in an increase to the size ofthe Scottish Government’s budget. While we would expect a positive relationshipbetween GDP per capita growth and tax revenues over a period of several years,the relationship depends on a number of variables and some of these are discussedin more detail below.

Table 2 shows the SFC’s forecast reconciliation figures for income tax for 2017/18,2018/19 and 2019/20.

The SFC explain that—


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In the UK, growth in tax revenues, and particularly income tax, has been morepositive than expected over the last two years. When compared to slowergrowth in Scottish income tax revenues over the last two years, this means

negative reconciliations in the years ahead. 11

The size of the reconciliations is a consequence of forecast error in not foreseeingthe differential performance of the growth in UK and Scottish income tax receipts.The key point is that higher per capita growth in income tax receipts in the UKcompared to Scotland for 2017/18 and 2018/19 has a negative impact on the size ofthe Scottish Budget. This negative impact would occur even if the forecasts werecorrect; if the forecasts at the time when the Scottish Budget was introduced for2017/18 and 2018/19 were more accurate then the Scottish Government wouldhave had less funding to allocate for both of those financial years.

The Cabinet Secretary told us that it “does feel perverse that, when income tax isrising, overall tax take is up, gross domestic product is performing positively,unemployment is low and earnings growth has been increasing, we will have

negative reconciliations over three years.” 12

The Committee’s primary concern is the extent to which the risks andopportunities for the Scottish Government’s budget arising from tax devolutionand the operation of the Fiscal Framework are as intended or whether there areunintended consequences which need to be more closely examined. Thepublication of outturn data for income tax for 2017-18 provides the firstopportunity for more detailed examination of these risks and opportunities andthis is discussed below.


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Scottish Income Tax 2017/18 –Reconciliation Process16.

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As the Committee has highlighted in previous budget and pre-budget reports, theScottish budget is exposed to broadly two types of budget risk through the FiscalFramework—

• The first is the risk that the Scottish income tax base grows relatively moreslowly than the equivalent income tax base in rUK. If this happens, thenScottish revenues are likely to be lower than the block grant adjustment. Theimplication of this is that the Scottish budget is worse off than it would havebeen had tax devolution not occurred;

• The second is the risk of forecast error. This is the risk that a Scottish budget isbased on a set of forecasts that turn out to have overestimated the level offunding available to the Scottish Government. If this happens, then asubsequent budget will need to address any shortfall.

It is important to note how these two risks interact. The first risk relates to the actualannual per capita growth in the level of Scottish income tax receipts relative to thelevel of per capita growth in the rest of the UK. The extent of this risk, therefore,does not become fully apparent until the outturn figures for income tax arepublished by HMRC.

The level of the second risk depends on the extent to which both the OBR and theSFC are able to accurately anticipate the extent of the first risk. This is explained bythe SFC as follows—

If, for structural reasons, Scottish income tax revenue is going to grow moreslowly than UK income tax revenue, that is a problem for the Scottish budget.At the moment, it is showing up as reconciliations because the forecasters didnot anticipate it. Once we start anticipating it, it will be built into the budget andthe forecasts. That does not mean that it will go away; it will just pop up in thebudget instead of in reconciliations.

Source: Finance and Constitution Committee 05 June 2019, Professor Smith, contrib. 9013

This means that, even though the forecasts may become more accurate over timeand the size of the reconciliations become therefore smaller, the risk for the publicfinances does not necessarily reduce. Rather, any continuing risk arising fromslower Scottish income tax growth relative to the rest of the UK would need toaddressed by the Scottish Government when setting its budget rather than throughthe reconciliation process.

The income tax outturn data for 2017-18 provides the first opportunity for theCommittee to examine in detail the extent of these risks. The timeline for thereconciliation process for 2017/18 is set out below.


5

Source: Scottish Government Fiscal Framework Technical Notei

21. Following HMRC’s publication of the outturn figures in July 2019, the impact on theScottish Budget can be calculated as set out below.

i https://www.gov.scot/binaries/content/documents/govscot/publications/publication/2019/05/scotlands-fiscal-outlook-scottish-governments-medium-term-financial-strategy-2019/documents/fiscal-framework-technical-note/fiscal-framework-technical-note/govscot%3Adocument/fiscal-framework-technical-note.pdf


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When the 2017-18 budget was agreed by the Scottish Parliament in February 2017,the level of Scottish income tax receipts was forecast to be £107m higher than theforecast Block Grant Adjustment (BGA). However, the outturn figures published byHMRC in July 2019 show that in fact Scottish income tax receipts were £97m lowerthan the BGA. This means that, based on the outturn figures, the 2017/18 budgetshould have been reduced by £97m rather than increased by £107m. Thereconciliation figure is, therefore, £204m. This will be deducted from the 2020-21budget.

The 2017/18 budget is now £97m lower than if income tax had not been partlydevolved as a consequence of the first risk discussed at paragraph 16 above. Thisis despite the higher rate threshold being frozen in 2017/18. The second riskdiscussed above, which is forecast error, results in the 2017/18 budget being afurther £107m lower.

The Fraser of Allander Institute state that “it’s important to not lose sight of theunderlying driver of these errors on this occasion – that is the implication fromScotland’s tax base performing less well than the equivalent tax base in the rest of

the UK.” 14 Our Fiscal Framework Adviser points out that this is largely explained by


7

Earnings Growth

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slightly faster growth in average earnings in rUK than Scotland. This is discussedbelow.

Table 3 below shows the forecast and outturn growth in income tax determinants inScotland and the UK for 2017-18.

Per cent growth Determinant Forecast Outturn Error (%)Employment 0.3 1.5 -1.2

Average earnings 2.3 1.0 1.3Scotland (SG)

Total earnings 2.6 2.4 0.2Employment 0.1 1.0 -0.9

Average earnings 2.4 2.7 -0.3UK (OBR)

Total earnings 2.5 4.0 -1.4


The SFC explained to the Committee that the “important thing is the growth rates oftotal earnings.” As shown in Table 3 the outturn in Scotland was 2.4 per cent and inthe UK it was 4%. The SFC state in their evaluation report that the “reconciliation of-£204 million can be explained by slightly faster than expected growth in earnings inthe rest of the UK and slightly slower than expected growth in earnings in Scotland.”15

Our Adviser points out that average Scottish earnings growth – the key determinantof growth in income tax revenues – has been slightly slower than average UKearnings growth for several years now and that the magnitude of this differentialvaries depending on the data source considered.

Chart 1 shows that, according to the two major labour market surveys, Scottishearnings growth exceeded UK earnings growth throughout the 2000s and early2010s, but that this has gone into reverse in more recent years. The exact extent ofweaker Scottish earnings growth differs according to the two surveys, but thegeneral observation is common to both.


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Chart 1: Average Scottish earnings as a percentage of average UK earnings

Source: Labour Force Survey and Annual Survey of Hours and Earnings

29.

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Our Adviser points out that between 2002 and 2013 there was a remarkableconvergence of Scottish earnings to the UK – average Scottish earnings were91.5% of the UK average in 2002 (i.e. 8.5% below UK earnings) but were just 3%below UK earnings by 2013. In other words, Scottish wages grew more quickly thanUK wages during this period, although remain slightly lower than the UK onaverage.

Between 2013 and 2016 there was no further convergence of Scottish earnings tothe UK average. Moreover, in 2017 and 2018 Scottish average wages grew lessquickly than in the UK. This relative slowdown in Scottish wage growth is alsoreflected in a relative slowdown in ‘real time’ PAYE tax data published by HMRC.Our Adviser suggests that understanding the causes of the relative Scottishearnings slowdown is an ongoing priority – as is determining what the ScottishGovernment’s policy response should be.

Another data source that has become available more recently is HMRC data onaverage PAYE earnings growth from taxpayer returns (Chart 2). This data showsthat Scottish earnings growth has been weaker than rUK earnings growthconsistently since 2015/16 (although the gap is narrowing year on year).


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Chart 2: Growth in PAYE earnings employment per taxpayer

Source: HMRC, Real Time Information

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35.

In the Committee’s report on the Budget 2019/20 we noted that the SFC hadsuggested that there is some evidence that slower earnings growth in Scotland is“due to the disproportionate level of higher taxpayers in the rest of the UK relative to

Scotland.” 16 The Committee explored this further in evidence with the SFC and theCabinet Secretary as part of our all year round budget scrutiny.

The SFC told us in June 2019 that the “likeliest single explanation” of the recentdifference in earnings growth between Scotland and the rest of the UK is that thelatter “has a higher concentration of higher-rate taxpayers and the recent growth in

UK income tax revenue has been concentrated among them.” 17 They explainedthat neither they or the OBR were aware that the recent growth in income taxrevenues “would be so strongly affected by distributional issues” and that had theybeen aware “Scotland would have had a smaller budget two years ago and we

would not need a reconciliation now.” 18

A key question for the Committee is whether these distributional issues arestructural and may therefore continue to have a negative impact on the size of theScottish budget. The SFC told us that “there is perhaps a structural issue with

regard to the labour market in Scotland and that in the rest of the UK” 19 and that it“seems to be a feature of the structure of the Scottish economy that Scotland has

fewer higher rate taxpayers. 20

Audit Scotland (Exhibit 15 21 below) point out that the Scottish income tax outturnstatistics for 2017/18 show that as a proportion of its income tax receipts—


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36.

37.

38.

• the Scottish Government has a higher proportion of its receipts from basic andhigher rate tax payers;

• the UK government has a higher proportion of its receipts from additional ratetaxpayers.

Audit Scotland also point out that “additional rate taxpayers in the rest of the UKaccount for 1.1 per cent of taxpayers (308,000 taxpayers) compared to 0.5 per cent(13,800 taxpayers) in Scotland.” This means that if “growth in the economy leads totax receipts more heavily linked to the incomes of people in a particular tax band,

this would affect Scottish and rest of the UK tax receipts differently.” 22

The Resolution Foundation told us that “Scotland has a less unequal paydistribution because it does not have as much at the very top. It has about the same

as the rest of the UK, minus London and the south-east.” 23 Professor David Bellexplained—

Like it or not, we have very unequal income distribution, with the people at thetop tending to pay a lot of the income tax. We are, nevertheless, less unequalthan the rest of the UK. The difference in average earnings between Scotlandand the rest of the UK is not really a great indication of income tax revenues,because people who are being paid the average will not actually pay that muchincome tax—it is the high earners who contribute a lot of the overall revenue.

Source: Finance and Constitution Committee 24 April 2019, Professor Bell, contrib. 4224

The Resolution Foundation explained that if “you want higher income tax revenues,

you need pay growth at the top." 25


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39.

40.

41.

Chart 3 shows the ratio of those whose earnings are greater than 90% of other workers tosomeone whose earnings are only greater than 10% of other workers. Thus, in 2018 inScotland, the worker at the 90th percentile earned 3.1 times more than the worker at the10th percentile.

Chart 3: Wage Inequality: Ratio of 90th to 10th Percentile for Full-Time Workers

Source: ASHE

Professor Bell stated in written evidence to the Committee that “the figure showsthat on this measure, income inequality in Scotland is lower than in the UK as awhole and has been falling since 2012.” He explained that the “difference betweenScotland and the UK as a whole largely stems from the relative scarcity of very highearners in Scotland” and that “the fall in this ratio over this period is likely to havebeen partly driven by above inflation increases in the minimum wage.” He alsostates that although “there may have been a recent decline, compared to other

European countries the UK has very high levels of inequality.” 26

Chart 4 shows the growth in annual earnings across the income distribution in2017-18 in Scotland compared to the UK.


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Chart 4: Growth in annual earnings across the income distribution, 2017 - 2018

Source: ASHE

42.

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Welsh Fiscal Framework

44.

The chart shows that while average earnings growth is slightly lower in Scotland,

earnings growth in Scotland was higher from the 20th percentile to the 70th

percentile, whilst earnings growth in the UK is higher at the bottom decile and in thetop 30% of the distribution. This provides some evidence therefore that the relativegrowth of income tax revenues per capita in 2017/18 may be partially the result ofrelatively faster growth in the incomes of the higher paid in rUK, rather than simplybeing an issue of relatively faster earnings growth across the distribution. However,it is worth pointing out that more recently published earnings data shows theposition between 2018 and 2019 to be the reverse of this – Scottish earnings at thetop of the earnings distribution grew more quickly than in the UK. The Committeewill examine closely the impact of this data on the outturn data for income tax for2018/19 when it is published in July 2020 and the subsequent reconciliation figure.

The Cabinet Secretary’s view is that there “might be a structural issue around

higher-rate taxpayers and deepening inequality in the rest of the UK.” 27 In his view“inequality in the rest of the UK is deepening as the top earners are earning moreproportionately and as a quantum.” On this basis he suggests that “there is a casefor the for the UK Government to reflect and acknowledge that the issue is not

about economic performance, but about increasing inequality in the UK.” 28

An important difference between the Scottish Fiscal Framework and the subsequentFiscal Framework agreed for Wales was the creation of a separate BGA for each


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band of income tax in Wales (the basic, higher and additional rates). On applyingthe adjustment to each band of income tax, the Welsh Fiscal Framework states—

As the composition of the income tax base in Wales is significantly differentfrom the UK average, the two governments have agreed that the Comparablemodel will be applied separately to each band of income tax (basic, higher andadditional rate). This ensures the new funding arrangements will deal with anyUK government decisions to change the UK-wide income tax base (forexample changes to the personal allowance) entirely mechanically. It willensure the Welsh Government’s tax revenues are broadly unaffected by UK

government policy decisions. 29

This recognises the significant difference in the Welsh income tax base comparedwith the rest of the UK. A much greater share of Welsh taxable income is earned atthe basic rate of income tax, compared with the rest of the UK. The implication ofthis different distribution is described by the Welsh Governance Centre thus—

This means that UK-wide factors which disproportionately impact taxableincome at the basic rate band have much more of an impact on total taxrevenues in Wales compared with the rest of the UK. For example, aboveinflationary increases in the personal allowance in recent years havesignificantly reduced taxable income at the basic rate, resulting in a much morepronounced impact on total Welsh revenues than in the rest of the UK.

“Conversely, the much greater share of taxable income earned at the additionalrate in the rest of the UK means that UK-wide factors which influence taxableincome at the additional rate will have a much greater impact on total revenues

in the rest of the UK than is true for Wales. 30

Our Adviser points out that creating separate BGAs for each income tax bandmeans that the BGA is likely to match the trends in devolved Welsh revenues moreclosely than it would have using a single BGA for income tax as a whole.

The Committee asks that the Cabinet Secretary provides the data which supportshis view that "inequality in the rest of the UK is deepening as the top earners areearning more proportionately and as a quantum."

The Committee, while mindful that we only have the first year of outturn data forScottish income tax, notes that there are two potential structural issues relating tothe operation of the fiscal framework arising from that data and from earningsdata as follows—

• The extent to which the distribution of the tax base is more unequal in rUKrelative to Scotland;

• The extent to which annual earnings growth is more unequal in rUK relativeto Scotland.

This raises two further questions—

• If economic growth in rUK disproportionately benefits higher-rate andadditional-rate taxpayers relative to the distribution of the benefits of


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Managing the Risk

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economic growth in Scotland, what does this mean for Scotland’s publicfinances;

• What policy responses are available to the Scottish Government to addressthis impact.

The Committee recommends that the OBR and the SFC reflect on thesedistributional issues in advance of the next round of income tax forecasts. TheCommittee also recommends that the SFC examines whether these distributionalissues are observed in the SPI data for 2018/19 data when that becomesavailable and writes to the Committee with its findings.

The Committee also notes that the Fiscal Framework agreement for Walesincludes separate BGAs for each band of income tax to reflect differences in theWelsh tax base compared to rUK. The Committee recommends that the review ofScotland’s Fiscal Framework should consider the impact of differences in theScottish income tax base relative to rUK.

The Committee has consistently called for the risks arising from the operation of thereconciliation process to be closely monitored and to be effectively andtransparently managed. However, we note that despite the size of the forecastnegative reconciliation, the MTFS does not address how the Scottish Governmentintends to manage this risk. The Scottish Parliament Information Centre (SPICe)point out that it is surprising that there is “a lack of detail as to how the ScottishGovernment might meet the challenge presented by a possible £1 billion

reconciliation over the next three financial years.” 31

The Fraser of Allander Institute also note the—

lack of assessment as to what – in the government’s view – explains the recentdifferences in tax performance between Scotland and rUK. And crucially, SFC’s£1bn worth of income tax reconciliations between 2017-18 and 2019-20. Youmight also think that a medium term financial strategy document might detail

how it will manage such a hit to revenues. But it doesn’t. 32

The Auditor General for Scotland highlights that there is no detail in the MTFS “onhow the Scottish Government would address a possible £1 billion shortfall due toforecast errors” and “little evidence to demonstrate that the strategy is a key

component of the government's financial decision-making.” 33 Audit Scotland pointout that the “absence of high-level financial plans, priorities and scenarios will make

the Parliament’s scrutiny of the forthcoming 2020/21 budget more difficult.” 34

The SFC’s view is that—


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57.

58.

These negative reconciliations mean less money will be available for futureScottish Budgets. The Scottish Government will be able to manage some ofthis through borrowing or use of the Scotland Reserve. However, the borrowingpowers available to the Scottish Government and the rules about withdrawingfunds from the Scotland Reserve mean that these will not cover all of theexpected reconciliations. The Scottish Government would have to adjust itsspending plans or increase taxes, and this should be borne in mind when

formulating current policy. 35

The Committee questioned the Cabinet Secretary on the lack of any informationwithin the MTFS relating to how the Scottish Government intends to manage therisk arising from the reconciliation process. The Cabinet Secretary told theCommittee that the Scottish Government assume that the forecast reconciliationfigures “are correct for the purpose of having a plan to work our way through thereconciliations with the various tools at our disposal” and that the MTFS sets out

“the approach that we will take to tackle the reconciliation.” 36 The MTFS statesthat—

Once outturn data is published a reconciliation and a budget adjustment areagreed for the financial year thereafter. The Scottish Government willsubsequently manage any negative or positive variance from the initiallyagreed budget position. The Scottish Government will closely monitor any risks

arising from the net BGAs. 1

The Cabinet Secretary was also asked by the Committee whether he would have toadjust his spending plans or increase taxes to address the forecast negativereconciliations. He responded that the main driver of the Scottish Government’sbudget “continues to be the block grant” and therefore “it is not true that it will

require just spending and tax adjustments.” 37 The Cabinet Secretary alsoemphasised the “inadequacy of the fiscal framework in dealing with that scale ofreconciliation” and, in particular, the “inadequacy of the resource borrowing

powers.” 36

While recognising the Scottish Government faces the challenge of not knowingthe quantum of the block grant, we are somewhat disappointed in the lack ofinformation in the MTFS regarding the forecast £1 billion negative reconciliation.The Committee invites the Cabinet Secretary to—

• Identify whether the expectation of the Scottish Government is that sufficientmoney to fund the negative reconciliations will be available through:

-resource borrowing;

-the Scotland Reserve;

-increases to the block grant.

• Provide an assessment of the likelihood of a structural risk to the ScottishGovernment’s budget arising from distributional issues in the tax base inScotland relative to rUK;


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Transparency

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• Provide some scenario planning relating to the extent of this risk includingpotential policy responses to address the risk.

The Committee will also write to the subject committees asking them to providedetails of the utility of the MTFS in informing their budget scrutiny and we willreport on this in our report on the 2020-21 Budget.

The Committee has repeatedly stated that full transparency is an essential elementin securing public confidence in the operation of the Fiscal Framework. TheCommittee has also previously noted that there is no agreed scrutiny process forthe reconciliation of outturn figures with forecasts. The challenges which this posesare illustrated by the reconciliation of the 2017-18 income tax forecasts with theoutturn figures published by HMRC in July 2019.

The Committee notes that, in particular, no official document has been published byeither the UK or the Scottish Government setting out the reconciliation process forincome tax for 2017-18 and how the figure has been calculated. Rather, we hadcompeting accounts of the reconciliation process in news releases published byboth the UK and Scottish Governments. The HM Treasury press release stated thatunder the reconciliation process, the block grant will be increased by £737m and

the Scottish Government’s income tax will be reduced by £941m.” 38 The headlineof the press release is “Scottish Income Tax shortfall offset by UK funding.”

The Scottish Government’s news release states that “the number of Scottish Higherand Additional Rate taxpayers combined, and the revenue paid by them, grew morequickly in Scotland than in the rest of the UK”, and that this “demonstrates thatconcerns taxpayers would relocate as a result of our tax policy choices were

unfounded.” 39 The headline of the press release is “Scottish income tax revenuesgrew by 1.8% in 2017-18.”

Our Adviser points out that HM Treasury’s interpretation is somewhat disingenuous.First, Scottish revenues were not £941m lower because of slower economic growth,but because outturn Scottish revenues in 2016/17 (which were not available at thetime the 2017/18 forecasts were made) were lower than anticipated. In other words,most of the explanation for the lower than forecast outturn data in 2017/18 reflectsthat revenues turned out to be lower than expected before income tax wastransferred.

Secondly, the UK Government did not offset this lower outturn with increasedfunding to reflect some risk-sharing mechanism; rather, the block grant adjustmentwas lower than forecast (i.e. less was deducted from the block grant) to reflect thelower 2016/17 outturn. The implication of this is that the UK Government had beencollecting less income tax revenue from Scotland than had been thought, and as aresult was implicitly foregoing less revenue by transferring income tax to Scotland.


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The Fiscal Framework contains no ‘risk-sharing mechanism’ that protects theScottish budget from slower than rUK growth – the Scottish budget is exposed infull to any such divergence.

The Fraser of Allander Institute state that we’re “puzzled why the UKG chose such

language, particularly given the way it has been subsequently interpreted.” 40

The Scottish Government requested that the UK Statistics Authority (UKSA)consider that HM Treasury’s view that there was a “£941m shortfall in Scottish taxrevenues due to lower growth in Scotland” in 2017/18 was inaccurate. Theyresponded that—

We agree with you that this is incorrect. The principal reasons for the blockgrant adjustment were in fact an initial overestimate of the Scottish tax base

and faster growth of tax receipts than expected in the rest of the UK. 41

The UKSA subsequently wrote to HM Treasury recommending—

future HM Treasury press statements based on these statistics provide betterexplanations of the causes of changes to the Scottish income tax revenues andthe associated Block Grant Adjustment. This will reduce the risk that usersdraw misleading conclusions from the statistics and the statements that draw

on them. 42

They also suggested that “to fully inform the public it would be helpful to present thisframework in line with our Code of Practice for Statistics, considering how the

statistics can be best presented in a clear and unambiguous way. 42

With regards to the Scottish Government’s news release, our Adviser points outthat, given that the higher rate threshold was frozen in Scotland but increased bymore than inflation in rUK, we would expect the number of higher rate taxpayers togrow more quickly in Scotland than rUK. Moreover this in itself tells us nothingabout whether there was or wasn’t some taxpayer response to the tax changes.

The Fraser of Allander Institute argue that, given the complexity of the fiscalframework, “the onus must be on both governments to articulate how the frameworkis operating, the various changes from year-to-year and any risks, in astraightforward and transparent manner.” In their view, “the risk of not doing so –and seeking to score political points at every turn – is that confidence in the

underlying process of fiscal devolution could be eroded. 43

The Committee recommends that HM Treasury and the Scottish Governmentwork together to agree an approach to the reconciliation process which istransparent and which will increase public understanding of the FiscalFramework. The Committee recommends that consideration should be given tothe following—

• A document jointly agreed by HM Treasury and the Scottish Governmentshould be published annually setting out the income tax reconciliationprocess including a detailed explanation of the reconciliation figure;


18

Data

72.

73.

• This document should be published and sent to the Committee in early Juneand provide a provisional reconciliation figure based on the most recent setof OBR and SFC forecasts so as to allow Scottish Parliament scrutiny priorto our summer recess;

• Any adjustments to the final reconciliation figure following HMRC’spublication of the audited outturn figures can be provided in writing to theCommittee.

The SFC explained that quite small errors in the earnings forecasts are driving quitea lot of the reconciliation errors and that they have been asking for better and moretimely earnings data for Scotland. They suggest that one “of the things which couldhelp is pressure from the Committee on the Office for National Statistics (ONS) andthe Scottish Government to start thinking about and working on improving the

quality of earnings data in Scotland. 43

The Committee asks the Scottish Government and ONS to provide an update onwhat progress has been made in improving the quality of earnings data inScotland.


19

Policy spillovers74.

75.

76.

Personal Allowance

77.

78.

79.

The Smith Commission stated that there should be no detriment as a result of UKgovernment or Scottish Government policy decisions post-devolution. Financialconsequences of policy decisions are known as policy spillovers and are covered

under the Fiscal Framework agreement 44 which states that—

where either government makes a policy decision that affects the tax receiptsor expenditure of the other, the decision-making government will eitherreimburse the other if there is an additional cost, or receive a transfer from theother if there is a saving.

The Fiscal Framework divides these policy spillovers into 2 categories—

• Direct effects – these are the financial effects that will directly and mechanicallyexist as a result of the policy change (before any associated change inbehaviours);

• Behavioural effects – these are the financial effects that result from peoplechanging behaviour following a policy change.

The Committee also notes that the Fiscal Framework only applies to the directeffects of policy change.

The Committee noted the Scottish Government’s request that a “policy spillover” beconsidered in relation to the increase of the Personal Allowance for 2018-19 and2019-20 and agreed to write to the Chief Secretary to the Treasury (CST) askingher view as to whether the policy spillover provisions within the Fiscal Frameworkhad indeed been triggered by the decision of the UK Government's decision to

increase the Personal Allowance for 2018-19 and 2019-20. 45

In her response, 46 the CST said that the UK Government's position was thatConsumer Price Index (CPI) linked increases to the Personal Allowance in April2018 did not constitute a change in UK Government policy however, the UKGovernment did accept that the above inflation increases to the Personal Allowancein April 2019 and the freeze to Personal Allowance in 2020 does constitute achange in policy. She said that HM Treasury officials are currently considering theScottish Government's analysis of this issue and that—

If the Scottish Government and HM treasury agree on the methodologicalapproach, we will consider if any transfer of funding (in either direction) is duefor these years.

The Cabinet Secretary wrote to the Committee on 25 October 2019 47 , stating thathe has been unable to make progress with HM Treasury on the issue. He reiteratedhis view that he disagrees with the previous CST that inflationary increases to thepersonal allowance do not constitute a spillover effect. He points out that joint UKand Scottish Government guidance notes that “policy decisions in relation to


20

80.

personal tax that are not fully captured by the block grant adjustment mechanism”would be considered direct effect spillovers. He also points out that the WelshGovernment’s fiscal framework explicitly cites increases in the personal allowanceas an example of a direct spillover effect.

The Committee will write to HM Treasury seeking a written update on this issueand will invite the CST to give oral evidence on this issue and other aspects ofthe operation of the Fiscal Framework including the reconciliation process.


21

Additional Dwelling Supplement81.

Context

82.

83.

84.

85.

86.

87.

88.

The Committee held two evidence sessions on the Additional Dwelling Supplement

(ADS), a roundtable discussion 0n 29 May 48 and evidence from the Minister for

Public Finance and Digital Economy on 12 June 2019. 49 The Committee wasinterested in how ADS had been operating in practice and whether unintendedconsequences had arisen with the introduction of ADS. The Committee was alsointerested in the impact of ADS on Scotland’s housing market.

Since the introduction of Land and Buildings Transaction Tax (LBTT) in 2013, theScottish Government has introduced both primary and secondary legislation withthe purpose of amending the parent Act. It was amended by the Land and BuildingsTransaction Tax (Amendment) (Scotland) Act 2016 which introduced a 3%surcharge on the purchase of additional properties for £40,000 or more (ADS) from1 April 2016.

One of the policy objectives of the 2016 Act was that married couples, those in acivil partnership and cohabitants (those living as if a married couple) are treated forthe purposes of ADS as one economic unit in order to address the risk of propertiesbeing moved between individuals for the purposes of tax avoidance.

The intention was that the ADS could be reclaimed when purchasing a mainresidence where the sale of the former main residence took place within 18 months.However, the legislation required the additional amount to be chargeable if spouses,civil partners or co-habitants were jointly buying a home to replace a home that wasowned by only one of them. As a result, the relief could not be claimed in thisscenario as only one name appeared on the title deeds.

This meant that “the couple is being treated as one economic unit when determiningif the ADS applies, but not when it comes to determining whether ADS should berepaid.” In June 2017, the Scottish Government addressed this anomaly viasecondary legislation.

The Land and Buildings Transaction Tax (Additional Amount-Second Homes MainResidence Relief) (Scotland) Order 2017 ("the 2017 Order") was laid to provide thatthe ADS was not chargeable if the buyer was replacing the buyer’s only or mainresidence however, prior to this 2017 Order coming into force, it was chargeable ifcouples were jointly buying a home to replace a home that was only owned by oneof them. The 2017 Order allowed that in these circumstances, the ADS paid as twodwellings were owned, could now be reclaimed despite only one name being on thetitle deeds to the former main residence.

The Land and Buildings Transaction Tax (Relief from Additional Amount) (Scotland)Bill was introduced by the Scottish Government on 13 November 2017. Its purposewas to give retrospective effect to the amendments made by the 2017 Order.

The Committee issued a call for views on the Bill and took evidence from the thenCabinet Secretary for Finance and the Constitution at its meeting on 7 February2018. In its Stage 1 report, the Committee supported the general principles of the


22

Operation of ADS

89.

90.

91.

92.

Bill and also raised a number of issues which were outwith scope of the Bill butraised during its scrutiny concerning unintended consequences of tax legislation.

During the roundtable session in May 2019, witnesses told us that ADS wascomplicated to administer and it was difficult for people to understand when itapplies to them or if they qualified for relief.

We were told that this is further complicated by some unintended consequences ofthe legislation. Witnesses said that there have been cases raised wherebyindividuals have claimed their payment of the tax has been unjust and against thespirit of the legislation. The Law Society of Scotland (LSS) highlighted the followinganomalies which they believe needs to be addressed—

• couples who are planning to get married but who do not live together beforethey do and who have to sell a house that only one of them owns before theybuy a house in joint names;

• people living together but not in the house that they are going to sell, they livein another other house.

• Divorcing couples who have to pay ADS if one of them departs and buys a newresidence;

• ADS being payable on main properties and on any ‘granny flat’ or annexe.;

• A lack of clarity regarding at what point inherited dwelling is treated as ownedby the beneficiary;

• ADS being payable on low value shares in inherited dwelling;

• ADS being payable where someone’s old residence is rented not owned.

During evidence, the Minister said she was sympathetic to a number of theseissues however she would need a deeper understanding of the extent of theproblems before considering any changes to the legislation. Regarding the calls tochange the legislation, she told the Committee—

First, they highlight the need for us to think more generally about how we makechanges to devolved taxes. Secondly, in terms of the changes that are calledfor, we need to think about how we balance specific individual situations withthe potential for unintended consequences in a complex tax.

Source: Finance and Constitution Committee 12 June 2019, The Minister for Public Finance and Digital

Economy (Kate Forbes), contrib. 18350

Following the evidence session, the Committee wrote 51 to the Minister asking theScottish Government to work with Revenue Scotland to gather data regarding thenumber of people affected by each of these anomalies and, once collated, providethis information to the Committee.


23

93.

94.

95.

96.

97.

98.

99.

In addition, the Committee requested that the analysis of responses to the ScottishGovernment’s consultation on the future of devolved taxes is sent to the Committee.

In her response 52 , the Minister confirmed that she would provide the Committeewith the analysis of responses to the Scottish Government’s consultation on thefuture of devolved taxes when it is published.

She stated that the LBTT return does not allow for any detailed assessment as tothe reasons why taxpayers are due to pay the ADS, whether it be in relation tovarious joint buyer scenarios, purchases follow divorce or separation or because aproperty is being used as a holiday home or a buy to let. She said—

My officials will however work together with Revenue Scotland to explorewhether there are other sources of evidence which could be drawn on to offerthe Committee some commentary on the extent to which the varioushighlighted scenarios occur...I will also ask my officials to analyse the officialcorrespondence received since the introduction of the ADS in order to providesome supporting evidence.

The Minister wrote to the Committee on 28 October 2019 53 providing an analysisof all the correspondence to the Scottish Government related to LBTT since 1 April2016 when ADS was introduced. During this period the Scottish Government hasdealt with 162 cases which focused on ADS. During the same period ADS was paidin just under 75,000 transactions. Of the 162 cases, 31 involved cases relating tothe potential anomalies highlighted by the LSS above.

The Minister notes that this analysis, while recognising that it captures onlycorrespondence with the Scottish Government, does not suggest that the issuesidentified by LSS are widespread. At the same time the Minister recognises thatchallenging circumstances can occur in individual cases and she has asked herofficials to undertake further work on this matter. The Minister also encouragesrelevant organisations to come forward with any evidence they can provide tosupport further consideration of this matter.

Revenue Scotland received 859 queries relating to ADS between April andSeptember 2019 but they have written to the Committee explaining that thesequeries “are not held and recorded in the sort of detail that allows for a detailed

analysis of the issues that the Committee are seeking to explore." 54

The Committee notes from the available evidence, the potential anomaliesidentified by the LSS do not appear to be widespread. The Committee welcomesthe Minister’s acknowledgement that challenging circumstances can occur inindividual cases and that she has asked her officials to undertake further work onthis matter. The Committee requests that it is kept updated with the progress ofthis work.


24

VAT assignment100.

101.

102.

103.

104.

105.

106.

The Scotland Act 2016 provided for the first 10 pence of the Standard Rate of ValueAdded Tax (VAT), and the first 2.5 pence of the Reduced Rate, to be assigned tothe Scottish Government. The Fiscal Framework set out that VAT assignment wouldbe implemented in 2019-20 with a one-year transitional period during which VATassignment will be calculated, but with no impact on the Scottish Government’sbudget.

The assignment of VAT will be based on a methodology that will estimateexpenditure in Scotland on goods and services that are liable for VAT. The draftmodel for calculating Scottish VAT receipts was published in November 2018 andwas expected to be finalised by the Joint Exchequer Committee in spring 2019.Ongoing discussions between the UK and Scottish Governments on themethodology has meant that this has not yet been finalised so the initial plan fordetermining the Scottish Government's budget in part by forecast and finalestimated VAT receipts in Scotland from 2020-21 has been delayed.

Last year, during the Committee's budget and pre-budget scrutiny, the Committeeconsidered the methodology for VAT assignment for Scotland and noted that basingVAT assignments for Scotland on estimated figures could introduce further volatilityinto Scotland's public finances.

The Committee asked the Scottish Government to keep the Committee updated onthe development of the methodology used for assigning VAT to Scotland in advanceof it being finalised by the Joint Exchequer Committee in spring 2019.

Given the impact that VAT assignment will have on the Scottish Budget, theCommittee explored the issue further with stakeholders in a roundtable discussion

on Wednesday 13 March 2019. 55 Following this session, the Committee agreed to

write to the Scottish Government on the issues raised during discussion. 56

The Committee asked the Cabinet Secretary to respond to points made that themain challenge in assigning VAT was in how to calculate a robust estimate and thequestions which also arose around the data sources being used in the model, suchas the annual survey in hours and earnings, as opposed to real time informationfrom HMRC. The Cabinet Secretary welcomed the Committee's consideration of

VAT assignment 57 and gave evidence on 8 May 2019 on these issues 58 .

During evidence, the Cabinet Secretary explained his concerns centred on the factthat VAT assignment is based on survey data and estimates. He said—

We will never have outturn data; we will always be comparing one set ofestimates with another set of estimates. Unlike what happens with income tax,there will be no reconciliation... I am concerned about the accuracy of theassignation approach, given that we are talking about almost £6 billion ofrevenue. There is a lack of certainty about its accuracy.

Source: Finance and Constitution Committee 08 May 2019, Derek Mackay, contrib. 5759


25

107.

108.

109.

110.

111.

112.

In addition, he said that the potential impact of Brexit could affect the economy,consumption and VAT receipts and the Scottish Government did not know whetherthe impact of this on Scotland would be disproportionate. He explained that thisuncertainty and lack of data carries a disproportionate risk. He told us—

At the moment, we face uncertainty with Brexit, which could have an impact onthe economy. Given that we face volatility, added uncertainty and concernsabout the level of accuracy of the assignation process, it does not feel asthough we are in a position to sign off the proposal.


The Cabinet Secretary was asked about what level of risk would be tolerable andhad this been discussed with HM Treasury. He said the work undertaken to date onthe methodology has resulted in a high level of risk due to the inherent uncertaintyassociated with basing assignment on estimates. When asked about mitigation, theCabinet Secretary said—

The UK Government might propose things that I would be open to, such as nofinancial detriment, recognising that we cannot push and pull levers here to fixthe VAT issue. If the UK Government wants to respond with some sort ofprotection or mitigation, of course, I will engage with it constructively.

My point right now is that, short of that, not implementing VAT assignation untilwe have more data and a deeper understanding of what the model producesfeels like the right thing to do.


Following the evidence session, on 15 May the Cabinet Secretary wrote to the CST62 setting out his concerns about the proposed approach to assigning VAT inScotland confirming that—

As a result, the only appropriate course of action at present is to seriouslyconsider the case for a delay to the implementation of VAT assignment andreview the case at the time of the Fiscal Framework review.

On 2 October 2019 during pre-budget scrutiny evidence, the Cabinet Secretary wasasked what the current situation was regarding VAT assignment in Scotland. He toldthe Committee that he had written to the new CST expressing his concerns and thathe expects a reply 'fairly imminently' and will update the Committee. He said—

...if the UK Government can provide further solutions and remedies to thosechallenges, we can engage further. I am advised that a response to my requestis imminent, which I will share with the committee as quickly as I can.

Source: Finance and Constitution Committee 02 October 2019 [Draft], Derek Mackay, contrib. 6863

The Cabinet Secretary wrote to the Committee on 25 October 64 stating that a replyfrom the CST is expected in advance of the UK Government budget and that he willupdate the Committee once this has been received.

The CST has written to the Committee 65 stating that the transition period forScottish VAT assignment will be extended by one year with full implementation now


26

113.

114.

in April 2021. He states that while he considers the VAT assignment methodology tobe “fundamentally sound” he has “listened to the concerns raised” and in particular,“it is also necessary to identify and manage potential uncertainty in the underlyingsurvey data."

The Cabinet Secretary has written to the Committee 66 confirming that he is happyto agree to the delay of the implementation of VAT assignment. He also reiterateshis concerns about the robustness of the assignment methodology and states thatthe delay gives more time to consider those concerns and seek solutions.

The Committee invites the Cabinet Secretary to keep the Committee updated onprogress in seeking solutions and will invite Scottish Government and UKGovernment officials to give evidence once the further work they are undertakingis completed.


27

Conclusion

115. The publication of outturn data for Scottish income tax for 2017-18 is the firstopportunity to consider the real impact of income tax devolution on the Scottishbudget. This report has sought to highlight a number of lessons which can belearned from how the inaugural reconciliation process for income tax has worked.These can be summarised as follows—

• There is a potential structural risk to the Scottish budget arising fromdifferences in the distribution of the tax base in Scotland and rUK;

• There needs to be much more detail in the MTFS on the ScottishGovernment’s assessment of that risk and some scenario planning ofpotential policy responses to that risk;

• There needs to be a joint approach between the UK Government and theScottish Government to the reconciliation process which is transparent andincreases public understanding.


28

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pre-budget scrutiny 2020-21€¦ · policy spillovers _____20 personal allowance _____20 additional...

Documents

pre-budget scrutiny 2020-21€¦ · policy spillovers _20 personal allowance _20 additional...